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May 16, 2007

Short-Selling Tick Tests on the Front Burner

By Peter Chapman

Should market makers be able to short small-cap stocks on a downtick? Should exchanges be able to regulate short selling at all? Will the Securities and Exchange Commission green-light full-blown short selling by July 9, the day Regulation NMS goes into effect for broker-dealers?

Those are three of the more important questions outstanding in the wake of the SEC's proposal to permit unfettered short selling across stocks of all sizes. The regulator made its proposal last December, after sifting through data and observations made during the two-year-old Regulation SHO pilot.

The industry had until February to comment on the SEC's proposal. SEC officials say they will make a decision by June.

The SEC decided that shorting on a downtick or downbid did not harm market quality in the 1,000 securities covered by the pilot. Still, some observers cautioned the regulator to go carefully if it is considering extending Reg SHO to stocks smaller than those in the pilot.

The American Stock Exchange, which trades many small-cap names, told the SEC in a letter "to proceed with caution in extending or extrapolating any such conclusions beyond what the data justify."

The Amex is concerned about volatility in small-cap names if price tests are eliminated-the SEC's Office of Economic Analysis found that volatility increased in small-caps shorted without price tests.

Peter Chepucavage, a consultant with Plexus Consulting Group in Washington, D.C., also believes the SEC should consider not removing price tests for small-caps.

Chepucavage believes the SEC could decide to lift price restrictions on the bigger names, but maintain them on smaller stocks, if just for a year. "Historically, they have been very deliberate about this," Chepucavage said. "It would make a lot of sense."

Volatility is on the minds of New York Stock Exchange executives as well. They want the SEC to let them maintain some control over short selling of NYSE-listed securities. The SEC's proposal removes any authority over the practice the exchanges now hold.

The Big Board petitioned the SEC for the ability to control short selling during periods of rapid price decline. The exchange notes that markets did not experience any severe dips during the Reg SHO pilot and thus no conclusions about trading during such events could be drawn.

Most traders are in favor of removal of price tests. For many, the restrictions are only minor inconveniences, anyway. The Security Traders Association and the Securities Industry and Financial Markets Association have both encouraged the SEC to eliminate the tests quickly.

The two industry groups want the controls gone by July 9, when broker-dealers must be in compliance with Reg NMS. They argue that it is easier for firms to incorporate systems changes related to Reg SHO before, rather than after, Reg NMS goes into effect.